RJ Hamster
Software’s $2-for-$1 Problem
 Delivering World-Class Financial Research Since 1999 Editor’s note: AI may claim yet another victim…This technology has been disrupting all corners of the market. And software stocks have been among the most vulnerable.According to Joe Austin, senior analyst at our corporate affiliate Chaikin Analytics, there are still growth prospects for the software industry. But with the panic around AI, there’s also real risk.In today’s Masters Series, originally from the February 9 issue of the Chaikin PowerFeed daily e-letter, Joe explains whether the recent sell-off is a warning sign or an opportunity… Software’s $2-for-$1 ProblemBy Joe Austin, senior analyst, Chaikin AnalyticsPlenty of folks worry about AI eating their business…And software companies have already found out just how painful that is.The S&P North American Technology Software Index fell 15% in January. That marked its worst monthly performance since 2008.And the Power Gauge saw this coming…In our system, we measure the software space with the State Street SPDR S&P Software & Services Fund (XSW).The Power Gauge first turned “bearish” on XSW back in mid-November. And the fund has collapsed in recent months. Take a look…However, growth prospects for the software industry itself still look pretty good…Late last year, IT consulting and research firm Gartner projected that global software spending would grow by more than 15% this year.Industry forecasts project software sales will grow from around $900 billion in 2025 to about $2.9 trillion by 2035. That’s a compound annual growth rate of more than 12%.So is the current panic in the space creating opportunity… or are investors right to worry?The fear makes sense. AI will surely disrupt many parts of the software industry.But to gauge the real risk, you need to understand the economics of how software companies make money.And it all comes down to one important point many investors overlook…Recommended Links:Log In to Marc Chaikin’s New $5,000 Earnings DetectorIt’s a website that shows you which AI stocks could still rise 100% by spotting the biggest potential earnings beats before they occur. Last year alone, back tests show that you could have doubled your money seven times. Until February 17, get FREE access here (no purchase required).Washington’s ‘Project Vault’ Changes EverythingThe White House’s $10 billion resource-stockpile program turns the U.S. government into a massive buyer of these critical minerals, creating a once-in-a-generation chance to make extraordinary returns. That’s the urgent message the man widely considered to be the greatest resource investor of all time is sharing today. Get full details here BEFORE the White House buys.There’s often a big gap between when software companies book revenue and when they actually make money…I started covering software stocks in the 1980s.Back then, software was a product that you bought. I even remember when it came in a box, with CDs you had to install.But today, companies sell most software via subscriptions. Customers rent rather than buy.This is what the industry calls “SaaS” – or “Software as a Service.”Today, SaaS is the way the industry does business. It’s expected that SaaS accounted for 85% of all software sales last year.It’s easy to see why SaaS is popular. There’s no massive upfront capital expenditure. Customers pay monthly or annually instead.That shifts the cost of the software from a capital expense (hard to approve) to an operating expense (easy to approve).But for software companies, this model comes with two unique risks…The first is customer acquisition cost (“CAC”). That’s how much money a company spends to acquire a new customer.The second is the payback period on that investment. That’s how long it takes for those monthly subscription payments to cover the CAC.This model works as long as growth continues. New customer revenue keeps flowing in. That covers ongoing expenses. And it creates what looks like healthy cash flow.The software company uses new customer money to fund operations while waiting for older customers to pay back those acquisition costs.But when growth stops, the results are brutal.Let’s say a company needs 18 months to recover what it spent on a customer. If people start canceling after 12 months, the company is stuck.It poured millions into customers with no payback.And CACs for software companies have soared in recent years. They’re up more than 200% since 2017.For top-quartile software companies (the most efficient of the group), the average payback period is now 15.9 months. That’s up about 30% from 12.3 months, the average payback period in 2020.Today, software companies spend about $2 for every dollar of recurring revenue they acquire. That’s a two-year breakeven timeline before factoring in ongoing service costs.The payoff is still positive for most companies. But margins are shrinking fast. The gap between what companies spend and what they earn back keeps narrowing.The SaaS model works well so long as customers stick around. But AI threatens to break that assumption – by either offering cheaper alternatives or letting companies build solutions in-house.And that’s exactly what has been sending investors running for the exits…To keep an eye on this, I’m monitoring XSW. But for now, the Power Gauge says to stay on the sidelines…XSW gets a “very bearish” rating in our system right now. Looking at its individual holdings, 54 companies are “bearish” or worse… and 78 are in “neutral” territory. Meanwhile, only five are “bullish” or better.Everyone worries about AI eating their business. But software companies might have the most to lose, because their entire model depends on customers sticking around for years.It’s a problem that won’t resolve itself quickly. Until we see how AI reshapes customer-retention patterns, software stocks remain higher-risk.I’m not saying that every company in the space is doomed. But right now, the Power Gauge sees much better opportunities elsewhere.Good investing,Joe AustinEditor’s note: According to Chaikin Analytics founder Marc Chaikin, a brutal rupture is fast approaching the AI sector… and less than 2% of stocks will be spared.But if you understand what’s coming, you could avoid a devastating loss while also potentially doubling your money.With the Power Gauge’s help, you can position yourself for what’s coming. Click here to learn more.You have received this e-mail as part of your subscription to Stansberry Digest. 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